By Matt Quinn, CFA® March 2022
“In your life expect some trouble. When you worry you make it double. But don’t worry, be happy, be happy now.”
For your second quiz of the year, did those lyrics appear in Bob Marley’s song Three Little Birds? The answer is no. These lyrics were part of a hit song released by Bobby McFerrin in 1988 entitled Don’t Worry, Be Happy. It was the first a Capella song to climb to the top of the Billboard Hot 100 chart in September 1988, a year when Bobby McFerrin was named top male vocalist and claimed Grammy Awards for best song and record of the year.
If you have spent much time at a gas station or grocery store these days, there isn’t much to smile about given the drastic rise in food and energy costs we have seen the last few months. There isn’t much to be happy about when you look at returns in financial markets this year either. No matter what broad-based benchmark you use to measure returns in financial markets, odds are it’s down this year. Through 3/10/22, the S&P 500 Index and Bloomberg Barclay’s US Aggregate Bond Index had declined 10% and 5% year to date, respectively. Things look even worse for stock market investors if you use an International Index such as the MSCI EAFE Index or the NASDAQ 100 Index, which are down 12% and 17% year to date, respectively.
In the January 2022 version of the Legacy Perspective, Steve mentioned that we would not be surprised to see a 10% or greater decline in the stock market sometime this year. Statistically speaking, the odds were in favor of this prognostication coming true. After all, markets have corrected by 10% or more in twelve of the last twenty years, or 60% of the time. Given that we did not see the market pull back by more than 5% in 2021, this call seemed like a good bet.
What is perhaps more surprising to us is the volatility we have seen YTD in the bond market. While the bond market clearly headed in a negative direction to start the year given the prospects for rising interest rates, the bond market has seen somewhat of a return to its traditional safe-haven status following Russia’s invasion of Ukraine on February 24th.
So, are we worried and where do we go from here? Odds are favorable that either the stock or bond market will finish in positive territory when we close out 2022 on December 30th (December 31st is a Saturday). In the last 40 years, we haven’t seen a single year where both markets declined, although we did come close in 2018 when the bond market was flat, and the stock market declined a little over 4%. Since the bond market hasn’t posted negative returns in back-to-back years in the past 40 years, statistics slightly favor the bond market returning to green territory for the year. However, the Fed tightening cycle is likely to keep pressure on bond prices and offset the benefits of higher yields. As such, we wouldn’t rule out the chance of the stock market returning to positive territory before we close out the year. After all, the US stock market finishes a year in positive territory 70% of the time based on historical data.
What’s the roadmap we see to getting there? Here are a few things we are watching and worth considering:
- Interest rate policy – the stock and bond markets have already priced in a rather aggressive Fed tightening cycle set to commence this month. Federal Reserve Chair Jerome Powell recently indicated that he is “inclined to support a 25-basis point hike” given the current state of the employment market and prospects for even higher inflation following Russia’s invasion of Ukraine and knock-on effects to global commodities markets. Odds are that the Fed will follow up on this first hike with four to six more similar-sized hikes in 2022. While the conflict and related sanctions on Russia is adding further fuel to the inflation fire, Powell tempered expectations for a larger hike to kick off this tightening cycle by stating that “the near-term effects on the US economy of the invasion of Ukraine, the ongoing war, the sanctions, and of events to come, remain highly uncertain.” In other words, the Fed will continue to monitor data and likely take things slow. When it comes to Fed rate hikes, speed matters. Stock and bond markets usually respond favorably to steady and consistent rate hikes when compared to the past when the Federal Reserve has made sudden unexpected larger, GDP-crushing moves.
- The conflict in Ukraine – for the sake of the people in Ukraine, we are hoping for a quick resolution to the conflict that will hopefully minimize the loss of human life. The toll is already quite tragic based on the number of civilian deaths and unfolding humanitarian crisis related to the number of refugees streaming out of Ukraine. One way or another, we think it’s likely that the conflict itself will come to an end this year although the ongoing effects could last for several years. Geopolitical events tend to be short lived from a market perspective and given the small size of the Ukrainian and Russian economies relative to the global economy, the economic impact should be limited. Rising costs and the potential for cyber warfare have increased and the uncertainty may create some sort of pause in activity. This could slow global economic momentum but isn’t likely to put the global economy into a recession. After all, large parts of the global economy are still reopening as global Covid cases have declined. We see an inventory building boom continuing to support global economic growth. There is also likely to be a global rebound in defense spending and ongoing support for technology and cybersecurity spending because of the conflict, which itself is reversing the more recent trend towards de-globalization.
- Inflation – with the consumer price index rising nearly 8% year over year in February to its fastest pace in 40 years, the word “transitory” has clearly gone out the window. While we are hearing more and more about stagflation, a term used to describe an environment of high inflation and stagnant demand, we don’t expect those conditions to materialize given the strength of the labor market. In fact, we believe several things could cap inflationary pressures as we move through the year. As interest rates rise, margin calls and higher borrowing costs have already taken some of the speculation out of the stock market. Rising rates and costs will also likely impact demand for housing and autos as financing conditions become more challenging for many, again hopefully taking some of the speculation out of the market. Other than car collectors, who would have thought that used cars would become an appreciating asset and that used car parts would become more valuable than the cars themselves. Any resolution to the conflict in Ukraine would also likely reverse the recent meteoric rise in commodities prices and boost investor sentiment. Should prices stay high, then the best antidote for rising prices is a decline in demand.
- Wages – the labor market is historically tight and labor conditions are favorable for those looking for employment. Wages are rising, but not by enough to offset higher household costs for fuel and food. Wages, which increased at a 5% annualize rate in February, are likely to continue to rise to lure employees back into the workforce and help to offset the impact of rising household costs on discretionary consumer spending. While higher wages could curb margins for some companies, as Steve mentioned in his last perspective it’s important to find companies that have pricing power to maintain margins even in a rising labor and commodity price environment.
As always, we do our best work when we plan rather than try to predict the direction of markets. We will never rely on our own predictions when it comes to our clients’ financial independence and will instead rely on time-tested investment strategies and diversification to navigate through more challenging market environments. Although the wall of worry is high right now, we see plenty of things to be optimistic about from a fundamental perspective and hope we can remember 2022 more for its ending than the beginning. And if you are worried, “don’t make it double.” Sit back and listen to those two songs mentioned above and let us know what differences you find in the lyrics.
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